The Theory of Bounded Rationality Explained

"Human beings, viewed as behaving systems, are quite simple. The apparent complexity of our behavior over time is largely a reflection of the complexity of the environment in which we find ourselves."

―Herbert A. Simon, The Sciences of the Artificial

As humans, we have to constantly take decisions in life. We try to seek logic and reasoning behind every decision. However, in our decision-making process, is it always possible to be completely rational? All economic theorems are based on an assumption that human beings are perfectly rational.

However, there are various parameters that influence our decisions. Well, of course, that does not imply that all decisions of a human being are completely irrational. Every decision is simply influenced by many other factors, and is bound by certain restraints that might not result into the best or the optimum result.

The 'Theory of Bounded Rationality' was developed by economist Herbert A. Simon, who was awarded the Nobel Prize in Economics in 1978 for his study of decision-making. According to him, instead of choosing the optimum solution as per rational methods, humans tend to opt for something that is most satisfying to their aspiration level.

It is not possible for a human to consider all the alternatives, and analyze them without being biased. His decision might be colored with his own perspective, and may not be crystal clear and rational.

• Herbert A. Simon created the term satisficing, that states that instead of aiming for the optimum solution, humans tend to take decisions that set in their mind's mapping and fulfills all restraints.
• The 'Theory of Bounded Rationality' states that humans are incapable of taking purely rational decisions, and are often influenced by various factors.

• Examples of Bounded Rationality can be found in game strategy, management science, administration decision-making, economics, etc. For example, 'Bounded Rationality and Chess'. Chess is a board game that involves strategy building and analyzing the opponent's next move in order to take the decision of your own next move.

Following can be certain parameters that may be hindrances in making a perfectly rational decision.

The decision maker might not be aware of all the requisite information that will help take the optimum decision.

Humans have their own cognitive limitations. They might become biased or judgmental, or may not be able to process all the complex data available.

Time is one of the biggest constraints for a human being. He often has to make decisions in haste due to emergencies or need of the hour. For example, you forget to buy something, and remember it at the eleventh hour, and simply grab that thing from the first store which you come across, not bothering much about the price or the brand, or any other criteria.

It might be possible that humans, instead of trying to seek and analyze complex information, might even make use of heuristics, instead. Note: 'Heuristics' are short-cut techniques or thumb-rules that help in a decision-making process. However, they are prone to errors, and might not lead to the best conclusion.

The stock market is highly volatile. There is too much information to process, and it is constantly changing all the time. In this case, it is very difficult for any investor to take a completely prudent and rational decision.

☀ Suppose John, an investor, decides to make an investment in the stock market. Considering the unpredictable nature of the stock market, he uses certain heuristics to simplify his decision-making process. He uses well-established norms and tries to diversify his investments to reduce the risk.

It is highly impossible for any investor to process all the information of all the viable investment options in such a huge market, and make a completely rational decision. He might seek advice from his friends, or use past experiences to make a judgment.

☀ Similarly, an investor might need to sell his stocks immediately due to a financial crunch. Due to his time restraint, it might not be possible for him to wait for the stock price to be conducive enough to yield him optimum results.

These examples prove how we tend to ignore information due to a time constraint or other limitations. Information, in a highly complex environment, might be difficult for humans to process, and hence, they simplify their decision-making process, which might not give an optimum result.

Many authors have written about the influence of bounded rationality in economics, politics, consumer behavior, markets, games, organizational learning, etc.

In this book, first published in 1997, Herbert A. Simon has described how bounded rationality impacts our decisions and feelings. It portrays how managers take decisions in business organizations, in reality.

This book by Bryan D. Jones explores how our decisions are not influenced simply by outside environment, but are also impacted by our own judging skills. We may tend to ignore some information, that according to us, is of less relevance, or even use shortcuts while taking decisions.

Ran Spiegler describes consumers' limitations in behaving rational when it comes to buying decisions. Most consumers behave partially rational, leaving scope for ignorance, or the inability to compare the market prices of the product. The author describes its impact on the markets due to such irrational preferences of the consumers.

'Modeling Bounded Rationality' by Ariel Rubinstein
'Bounded Rationality: The Adaptive Toolbox' by Gerd Gigerenzer
'Bounded Rationality and Politics' by Jonathan Bendor